As Atlantic City, NJ is added to the list of municipalities in the U.S. facing complete insolvency, I expressed my dismay about the consequences of decades of fiscal irresponsibility to one of my colleagues, “Patty.”
Me: Who would ever buy municipal bonds in NJ again after what’s happening in Atlantic City?
Patty: Why not? My financial advisor just put me into a municipal bond ladder paying 4% tax-free. It’s great!
Me: Wow. My Vanguard Intermediate-Term Tax-Exempt Fund only has an SEC yield of 1.5%. Your financial adviser must be a genius.
Patty: <smug smile> Yeah, I’m pretty lucky I found this guy. Do you want me to give you his contact information?
Me: <rolling my eyes> No thanks.
In reality, my 1.5% yield kicks her 4% yield’s ass. How is this possible?
(1) Her financial advisor takes 1% of her assets every year in exchange for sitting on her bond ladder.
(2) Her financial advisor and brokerage firm get a hidden markup of 4% to 5% on bonds in their “inventory.” It is standard practice to place bonds in client accounts that are priced 4% to 5% higher than the brokerage paid for those bonds (and then they buy them back at an artificially low price). This hidden markup on buying and selling bonds into and out of “inventory” is part of your brokerage firm’s profit on the deal.
- higher liquidity risk (inability to resell the bond at a fair price)
- higher interest rate risk (for each 1% interest rates climb, her bond values decline 20%)
- higher inflation risk (if inflation rises, interest rates rise, long duration bond values decline the most)
- higher credit risk (as bond-ratings fall due to municipal insolvency, bond values decline)
- higher tax risk (if the tax-free status is eventually phased out, longer duration municipal bond prices will plummet)
(4) In order to boost returns up to that 4% yield, your financial advisor must go dumpster-diving to choose bonds with a lower credit rating. The lower the credit rating, the higher the risk of not getting your money back, due to rising municipal insolvency. When your bond gets an A rating, it is NOT like a 4.0 GPA. It is more like getting a C+, as it is only a couple notches above junk bond status. In reality, a rating of AAA is more like a 4.0 GPA. As the bond rating declines from AAA to AA to A to BBB to “junk” status, the value of your bond declines as the risk of not getting your money back rises.
So Patty’s bond ladder with a “4% yield” is NOT as safe as she thinks, nor does it actually yield 4% after subtracting out advisory fees, brokerage markups, declining value of the bonds themselves, and rising risk of losing everything.